Discretion Is Not the Better Part of Valour: Are Your Company’s Director Awards Entirely Fair?

01.11.18

Recently, the Delaware Supreme Court held that, except in certain limited circumstances described below, the more onerous “entire fairness” standard of review, rather than the deferential “business judgment” rule, will apply if a stockholder challenges a grant of equity awards to directors if the directors exercised discretion in granting the awards.

The “entire fairness” standard requires that directors prove that their compensation decisions are entirely fair (i.e., in both fair dealing and fair price) to the corporation and its stockholders. This higher standard will apply to compensation decisions even if stockholders have previously approved an equity incentive plan that contains meaningful, specific limits on awards to directors.

What happened

At issue in the case was a stockholder-approved equity plan that afforded the directors discretion to allocate up to 30 percent of all option or restricted stock shares available for awards to themselves. Notably, the plan did not impose any other limits on the grants that could be made to the directors. The directors subsequently awarded themselves equity awards under the plan, the total fair value of which topped $50 million.

After the company disclosed the awards in its filings with the SEC, the plaintiffs filed suit alleging that the directors breached their fiduciary duties by awarding equity awards to themselves that were excessive in comparison to compensation paid to directors of peer companies.

In its opinion, the court found that, consistent with directors’ fiduciary duties to act equitably in the best interests of the corporation, if the directors exercise any discretion in granting themselves compensation under an equity incentive plan, they will not be afforded the protection of the business judgment rule in a subsequent stockholder challenge unless (i) the stockholders approved the specific director awards, or (ii) the plan is self-executing, meaning that the directors had no discretion in making the awards (i.e., grants are made pursuant to fixed criteria or a pre-determined formula).

What you can do

We expect that this decision will result in increased litigation regarding the payment of director compensation.

Although this case dealt only with equity awards, we believe this will be true whether the compensation is comprised of equity awards, cash or both. Accordingly, prior to granting themselves awards, all boards of directors, even those of companies that have stockholder-approved equity plans containing meaningful, specific limits on awards that can be granted to directors, should review their plans and historical compensation payments with legal counsel to ascertain whether such grants either satisfy the “entire fairness” standard or would be afforded the protection of the “business judgment” rule.

For a company that determines that it is at risk of a stockholder challenge, it should consider, among other things:

adjusting director compensation so that it aligns more closely with the median of its peer company spectrum;

seeking stockholder ratification of awards previously granted to directors; and

implementing two separate incentive plans, one for non-employee directors and one for employees (if a company has one combined plan that grants directors discretion to make awards, the plan may be “tainted” such that every award issued pursuant to the plan, including awards made to employees, could be subject to the “entire fairness” standard).

In addition, companies should consider the opportunity that proxy statement narratives present in terms of communicating how and why the corporation’s director compensation practices are fair, competitive and reasonable.

Such narrative disclosure would likely describe:

The director compensation philosophy;

The process for determining director compensation;

The respective elements of director compensation;

The documentation of and rationale underpinning director compensation decisions;

The role that any compensation consultant plays in the process;

Whether the directors use benchmarks to compare the company’s performance to that of peer companies;

If the company benchmarks, the company’s peer group;

The comparison of the company’s director compensation program to that of its peers; and